Expert View: One more push, then US rates will reach the peak

I disagree with economists who say we're heading towards 6 per cent
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The Independent Online

The US Federal Reserve chief Ben Bernanke succeeded in pulling off a tough mission last week. First he convinced politicians that despite an apparent slowing in the economy - with worrying implications for employment in a mid-term election year - there may be the need for further interest rate rises. And then he calmed the financial markets' fears about the prospect of further rate increases in an environment of rising inflation.

Mr Bernanke struck a balanced tone when he presented the Fed's Monetary Policy Report to Congress. This document outlines what the US central bank sees as the likely path of the economy, and offers clues to what will happen to interest rates. Inflation has been the main theme concerning financial markets recently, as high energy and commodity prices push up the general level of prices. For the time being, though, labour costs and inflation expectations "remain contained", according to the Fed chief.

So-called "second round" effects, when employees start demanding higher wages to compensate for these higher costs, have not materialised. Indeed, the Fed has continued to predict a slowdown in activity, and Mr Bernanke says this "now seems to be under way". That means the Fed's "baseline is for moderating inflation".

However, there is some confusion as to what this actually means for interest rates. Despite predicting that inflation would gradually fall, the Fed has raised its forecasts relative to its last prognosis, published in February. Its favoured measure of inflation, because of its breadth, is the "core personal consumer expenditure deflator" (which excludes food and energy prices). This is now predicted to be between 2.25 and 2.5 per cent year-on-year in the fourth quarter of 2006, and between 2 and 2.25 per cent at the end of 2007.

The awkward bit is that some Fed officials had previously indicated that it had a "comfort range" of between 1 and 2 per cent. Are they therefore suggesting that the Fed will raise rates further?

Confusingly, in the Q&A session, Mr Bernanke said: "we don't have a target". Does this imply that the "comfort range" for inflation is higher than previously mentioned? Or that the Fed is happy that the adjustment process for inflation moving lower may take longer? Either way, this would suggest interest rates are unlikely to rise further.

I do not fully buy this. Mr Bernanke indicated that he is continuing with the risk-management approach to policy adopted by his predecessor, Alan Greenspan. He argued that "we must consider not only what appears to be the most likely outcome, but also the risks to that outlook and the costs that would be incurred should any of those risks be realised". The main risk at this stage is of inflation becoming embedded. If this happened, "persistently higher inflation ... would be costly to reverse".

There is also a credibility argument for the Fed to consider. If the central bank were to pause in August - neither raising nor lowering rates - it might discover that it has to raise rates further later in the year. This would risk the financial markets taking the view that the Fed had made a misjudgement, which could increase volatility.

If, on the other hand, it did go in August and then subsequently discovered that the extra 25 basis points of tightening was too much, that could be quickly reversed. All told, this suggests the Fed will increase rates in August to 5.50 per cent.

But I disagree with several market economists who are looking for American rates to head towards 6 per cent. Indeed, August will probably mark not so much the beginning of a pause, but the peak. Employment growth, the housing market and sentiment surveys are all weakening in response to tighter monetary policy and high energy costs. The risks are that, as the effects of earlier rate hikes are felt, this process will intensify and discussion of interest rate rises will give way to debate on the timing of rate cuts later this year.